Trim The Down Payment And The Profits Add Up

February 01, 1986|By Robert J. Bruss.

Q-I disagree with advice that home buyers should always make the smallest possible cash down payment and get the largest available mortgage. For example, if I can invest my money to yield 9 percent but a home mortgage costs 12 percent interest, I should make as large a down payment as possible because I`m earning 3 percent more by doing so. If the highest yield I can get on my money is less than a mortgage costs, doesn`t it make sense to make the biggest down payment I can afford?

A-No. As many home buyers have discovered, once you tie up cash in a down payment, it can be difficult to release it except by selling the property. Refinancing or adding a second mortgage to produce cash for emergencies or investments can be expensive and sometimes impossible.

Your approach overlooks the leverage advantage of a small down payment. To illustrate, suppose you buy a $100,000 house for $100,000 cash. Let`s presume you will ``save`` about $12,000 per year at 12 percent mortgage interest that you don`t have to pay.

Also, let`s presume the home appreciates in market value at the current national average rate of 5 percent annually. Your $12,000 saved plus $5,000 appreciation is a 17 percent return on the $100,000 cash which is tied up.

However, if you bought the same $100,000 house with a $10,000 down payment and got a $90,000 mortgage, at 12 percent interest, the mortgage costs $10,800 annually. But after considering the 5 percent market value appreciation, your net housing cost is only about $5,800 or about $483.33 monthly. Add the income tax savings for the interest deduction and your leverage advantage increases.

Another way to view the situation is the home`s $5,000 annual value increase is a 50 percent return on the $10,000 down payment investment.

But as a practical matter, most home buyers don`t have the cash to make a large down payment. They should be thankful because small down payments (1)

maximize mortgage interest tax deductions, (2) repay the loan with cheaper inflated dollars worth less than today`s dollar, and (3) a large existing assumable mortgage makes a home easier to sell for top dollar.

Q-We plan to sell our present home for about $125,000 and move to Florida where we have a house on a one-year lease-option. Our problem is the option purchase price is just $78,500. Our tax man says if we buy that house, we will owe tax on about $46,500 ($125,000 minus $78,500) of our approximate $60,000 sales profit. As we are not yet age 55 to qualify for the $125,000 once in a lifetime tax exemption, how can we avoid paying tax on the $46,500? If we also bought a second vacation home would that help?

A-Your tax man is correct. The rollover residence replacement rule (IRC 1034) allows home sale tax deferral when selling your primary residence and buying a replacement of equal or greater cost within two years before or after the sale. This tax rule applies to home sellers of any age.

However, when a less expensive replacement home is purchased, as in your situation, then the sale profit is taxable up to the difference in the two prices. Unfortunately, your idea of buying a second home won`t help because you can only have one principal residence.

But you can reduce the taxable profit by the amount of any capital improvements you add to your new home within the allowable two-year replacement period.

To illustrate, if you spend money for a room addition, landscaping, swimming pool, remodeling, or other improvements, add the cost to your $78,500 purchasing price. This reduces the price differences and your taxable profit. Another way to reduce your profit tax is to sell your old home on an installment sale. The result is to spread out the buyer`s payments over several tax years, thus avoiding boosting you into a high tax bracket in the year of your home sale.

Even if you owe tax on part of your profit, since you`ve owned your home more than six months, it will be taxed as a long-term capital gain. At worst you will owe a 20 percent tax. On $46,500 that`s only about $9,300.

Q-I have about $40,000 equity in my property and am thinking of refinancing it to get some cash. Since my mortgage is at 8.25 percent interest, would I be better off getting a second mortgage rather than refinancing with a new first mortgage? Will I owe any tax on the cash I receive from the loan?

A-There is no simple answer to your first question. Only by shopping among at least a half-dozen lenders and comparing their first and second mortgages as well as their fixed and adjustable rate loans can you decide which is best for you.

Generally, you will be better off leaving the first mortgage in place and getting a new 15-year second mortgage, probably around 13 percent interest in today`s market. Contact at least two S&Ls, two banks and two mortgage brokers to compare the alternatives.

To answer the second question, cash obtained by a loan is tax-free. The reason is you have to pay it back.